- Let’s examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
- We'll also evaluate the attractiveness of Best Buy's economic castle and explain why it is crumbling.
- Our favorite ideas are always included in the portfolio of the Best Ideas Newsletter.
"In business, I look for economic castles protected by unbreachable moats." - Warren Buffett
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not. Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages. We'll also evaluate the attractiveness of Best Buy's (NYSE:BBY) Economic Castle and explain why it is crumbling.
Image Source: Valuentum; EVA is trademarked by Stern Stewart & Co
<< Please take few moments to read through the information in the graph above. The notes have been reproduced in italics below. >>
Moat versus No-Moat: In this hypothetical example, a moaty firm's operations are more stable -- generating more sustainable and durable economic profits into the future (slowly fading blue curve). The no-moat firm's operations are much more volatile, generating economic profit and destroying capital at times (more volatile red curve). In this particular example, however, the moaty firm's total economic value creation (area of blue curve), in absolute and in present value terms, is significantly less than that of the no-moat firm (area of red curve), as calculated. In present value terms, the moaty firm generates less than half the economic profit of the no-moat company. The no-moat firm, in this example, is generating more value for shareholders than the firm with sustainable and durable competitive advantages.
The graph above represents a hypothetical future economic value added curve for a moaty company (NASDAQ:BLUE) and a no-moat company (red), where any area above the x-axis represents economic value added and any area below the x-axis represents economic value destroyed. The moaty firm never destroys shareholder capital, but the no-moat firm generates the most cumulative economic profit for shareholders, both in absolute and discounted terms. The no-moat firm ceases to generate economic profit or destroy capital at the end of Year 15 due to competitive forces, while the moaty firm continues to generate economic profit for significantly longer, through Year 25.
For those that may not be familiar with our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Best Buy posts a Valuentum Buying Index score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. Here is how we interpret the numerical scale for ideas for consideration in the Best Ideas portfolio.
Best Buy's Investment Considerations
• Best Buy earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 38% during the past three years.
• Best Buy is the global leader in consumer electronics as far as big box retailers go. We think the company must reinvent itself to survive competitive pressures from the likes of online powerhouse Amazon (NASDAQ:AMZN).
• Best Buy's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 1.3% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. However, the firm's cash flow should be sufficient to handle its low financial leverage.
• Best Buy will face a promotional environment in coming years like no other in its history. The costs associated with the firm's ability to retain holiday sales in 2013, for example, were significant, and the expenses to hold the line with market share may only intensify. Competition is unforgiving.
• Founder and former CEO Richard Schulze has indicated his desire to take Best Buy private in the past. Unlike other deals, we think this one has a key intangible that could help it get done--emotion. Still, the timing and details of any transaction are unknown. We're not ruling out the chance of another suitor coming along.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Best Buy's 3-year historical return on invested capital (without goodwill) is 38%, which is above the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Why Best Buy's Economic Castle Is Crumbling
The sustainability and duration of a firm's economic value creation - or its competitive advantage period - tells us little about a company's economic castle, or the magnitude of the value creation that it is expected to deliver to shareholders. Though a focus on economic moats is important to Warren Buffett's process, identifying "economic castles," or those that will deliver the most value to shareholders may be equally, if not, more important to an investor's process. We are keeping the horse before the cart.
Valuentum's Economic Castle™ rating assumes that 'economic profit' (as measured by ROIC less WACC) is the primary factor in assessing the value that a company generates for shareholders. Whereas an economic moat assessment evaluates a firm on the basis of the sustainability and durability of its economic value creation stream, Valuentum's Economic Castle™ rating evaluates a firm on the basis of the magnitude of the economic profit that it will deliver to shareholders (as measured by its ROIC-less-WACC spread). Firms with the best Valuentum Economic Castle™ ratings are poised to generate the most economic value for shareholders, regardless of their competitive positions.
A decline in the ROIC-less-WACC spread is an indication that a firm's Economic Castle is becoming less desirable. This is the case with Best Buy. Though we expect continued economic profit creation, its Economic Castle is metaphorically crumbling. Best Buy may still have an economic moat -- its returns are greater than its cost of returns (and my be for some time yet) -- but the Economic Castle assessment shows deterioration in the business. We think the objectivity of the Economic Castle rating is very useful.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Best Buy's free cash flow margin has averaged about 1.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Best Buy, cash flow from operations increased about 6% from levels registered two years ago, while capital expenditures fell about 25% over the same time period.
Our discounted cash flow model indicates that Best Buy's shares are worth between $22-$42 each. Shares are trading relatively close to the midpoint of the range, at roughly $29 each at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $32 per share represents a price-to-earnings (P/E) ratio of about 15.9 times last year's earnings and an implied EV/EBITDA multiple of about 5 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 0.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -5.1%. Our model reflects a 5-year projected average operating margin of 2.7%, which is below Best Buy's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of -4.7% for the next 15 years and 3% in perpetuity. For Best Buy, we use a 10.5% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Best Buy to peers Home Depot (NYSE:HD) and Office Depot (NYSE:ODP), among others.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $32 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Best Buy. We think the firm is attractive below $22 per share (the green line), but quite expensive above $42 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Best Buy's fair value at this point in time to be about $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Best Buy's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $42 per share in Year 3 represents our existing fair value per share of $32 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.